Sunday, November 6, 2011

Thinking Through the Implications of Italy Being Too Big to Fail

From Credit Writedowns:

Why Investors will buy Italian bonds after ECB monetisation

Disclaimer: These last three pieces on the impact of Italy’s potential insolvency on the sovereign debt crisis are not advocacy pieces. They are analysis – predictions of what I see as likely to occur.

Yesterday I wrote why questioning Italy's solvency leads inevitably to monetisation. The long and short of it is that Italy is too big to fail. Too many undercapitalised European banks own lots of Italian sovereign government bonds for Italy to default without causing a major panic and a run on euro zone banks, massive bank failures and a major Depression. Even if the German, French, Dutch or Austrian governments were to step in and try to recapitalise their banks after an Italian default, I am not sure they could prevent a bank run. Moreover, German, French, Dutch and Austrian sovereign credit ratings would suffer considerable damage and questioning their solvency would begin as well. That’s what it means to have no currency sovereignty and no lender of last resort. This affects every nation within the euro zone.

I also wrote in conjunction with Friday’s video clip from RT “how I would provide the backstop”. The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a penalty spread to Bunds - liquidity at a penalty rate - say 200 bps to German Bunds, which would be 3.8% on 10-year money. The ECB would not necessarily have to buy any BTPs to defend its target. The private sector “would do it” for the ECB via the language and confidence in the "guarantee". That’s how it works at the short end of the curve with the policy rate by the way and it is also exactly what the Fed did during the 1940s and 1950s; so we know ‘financial repression’ works. After an initial foray in the market to prove the credibility of the backstop and to ‘punish’ speculators , every speculator would blanch at going up against the ECB’s wall of liquidity for fear of insolvency. I added the part about speculators because that’s how policy makers in Europe think about this crisis.

The point is that this is a moral hazard. The only way to credibly force countries within the euro zone to get onboard with fiscal tightening is fiscal integration. That's why a future rump Euro will have it or be comprised of more similar national economies. In the absence of fiscal integration, you have these makeshift policies of moral suasion and empty threats. In Ireland, Portugal and Greece’s cases, the threats are more real because those economies are small. The ECB would not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece, Portugal or Ireland. However, Italy and Spain are too large to believe this threat is credible.

Now I don’t really think anyone who has run through the financial sector balances would claim fiscal integration or fiscal tightening is in the interest of Germany’s mercantilist trade policy since the euro zone is one giant vendor financing scheme. If the periphery tightens fiscally, this is unlikely to significantly reduce net savings in the private sector and is therefore, likely to have a big negative impact on German exports and economic growth. But what choice does the euro zone have. Either accept the fact that Germany must finance the periphery in order to sell their wares there or face shrinking export demand and economic growth. This is exactly the same dynamic we see between the US and China. Michael Pettis called it the “Dilemma over current account vendor financing”.

To sum up, the euro zone is in an existential crisis, brought on by fiscal, private sector and current account, imbalances in a fixed exchange rate environment lacking a lender of last resort. The morality of the economics of this situation are only relevant in regard to the economic nationalism to which these kinds of morality plays give rise. On the other hand, this arrangement necessarily means that some countries within the fixed exchange rate imbalance will eventually suffer a sovereign debt crisis due to the imbalances. Without a lender of last resort, such a crisis becomes existential as default is inevitable without at least an implicit backstop from the central bank. And sovereign default would inflict huge losses on sovereign creditors, cascading the insolvency down the line to the banks.

My conclusion: the ECB will backstop Italian (and Spanish) debt. What that means for Portugal, Ireland, and Greece, I don’t know.

The likely impact of this kind of action is an increase in expected nominal GDP in the euro area. If these expectations don’t include an increase in future real GDP within the euro area, monetisation would lead to a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So, in that case, this could be considered a beggar thy neighbour economic policy – competitive currency devaluation, if you will. It may invite reactions from the US and other currency areas....MORE